Debt consolidation is a financial strategy that involves combining multiple debts into a single loan or line of credit. Consumers may choose to consolidate their debts for one or more reasons:
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To simplify their monthly payments,
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To reduce interest rates, or
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To reduce monthly payments.
What You Should Know About Debt Consolidation Loans
Single Payment
Instead of making multiple payments to a variety of creditors, you make one monthly payment to the consolidation loan provider.
Lower Interest Rates
Debt consolidation loans often come with lower interest rates, particularly if the debt consolidation loan is secured or you have a good credit score.
Lower Monthly Payments
Debt consolidation can extend the repayment period, reducing the monthly payment amount but potentially increasing the total interest paid over time.
Types of Debt Consolidation Loans
Personal Loans
Personal loans are usually unsecured loans used to pay off high-interest debts. “Unsecured” means that borrowers do not provide collateral, like a home or vehicle, to secure the loan.
Unsecured personal loans can be obtained from traditional banks, credit unions, online lenders, and other agencies specializing in consumer loans. While almost every borrower can qualify for a personal loan, banks and credit unions are usually more selective.
Credit unions and online lenders typically offer the lowest interest rates. However, other agencies may lower rates occasionally to stay competitive. Of course, borrowers with higher credit scores will be offered the best terms, including the lowest interest rates and longest repayment periods.
Personal loans are like car loans or mortgages in that the principal and interest, as well as any origination fees, are paid off in equal monthly payments over the loan's term, which is usually between 12 and 60 months (1-5 years).
Key Takeaways
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Personal loans offer lower interest rates.
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Most applicants will qualify.
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Payments are made in equal monthly installments for a specified amount of time.
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Personal loans sometimes incur origination fees.
Balance Transfer Credit Cards
Balance transfer credit card offers are usually only available to consumers with very good or excellent credit, so don’t plan on getting a balance transfer offer unless your credit score is 740 or higher.
If you have built and maintained excellent credit, you can expect offers to arrive via traditional mail, email, or other digital notifications.
Credit card companies offer low or 0% introductory interest rates to pay off other debts electronically or with convenience checks. These introductory rates typically last for 6 to 18 months.
When the introductory rate is over, you can expect the regular interest rate to be well over 20% in today’s market. There is usually a balance transfer fee that is equal to a small percentage—3 to 5%—of each transaction. So, if you are transferring debt from multiple accounts, you will pay a transfer fee for each one.
As with any credit card, monthly payments are dependent upon the balance on the credit card, so payments will vary. You will be required to pay a minimum monthly payment, but paying only the minimum amount will leave you with a balance after the introductory rate expires.
Key Takeaways
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Balance transfer credit cards offer low or 0% introductory interest rates.
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Only consumers with very good to excellent credit will qualify.
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Variable minimum payments are due monthly.
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Balance transfers typically incur balance transfer fees.
Debt Management Plans
Debt management plans are arranged through credit counseling agencies that negotiate with creditors for reduced interest rates and consolidated payments. Some credit counseling agencies are nonprofit organizations that charge nominal fees for their services. Other credit counseling agencies are for-profit companies that charge higher fees than non-profits.
Both usually require a one-time enrollment fee and recurring monthly fees to continue to manage the account and advocate for clients with creditors.
Most applicants will qualify for a debt management plan, regardless of credit score, because they will be required to close out all current credit accounts and will not be allowed to take out new lines of credit until the terms are satisfied.
Borrowers should do their due diligence to find out if the organization or company they are working with is a nonprofit or for-profit entity. You would also do well to compare enrollment and monthly fees across multiple credit counseling agencies before deciding which debt management plan is right for you.
Both types of credit counseling agencies review a client’s monthly income, bills, and revolving credit accounts to create a budget that includes a fixed monthly payment to repay the client’s consolidated debt.
Key Takeaways
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Credit counseling agencies negotiate for lower interest rates.
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Most applicants will qualify.
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Current lines of credit will be closed. No new lines of credit can be opened.
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Payments are made in fixed monthly installments.
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Debt management plans incur enrollment and monthly fees.
Home Equity Loans
Equity is the value of the portion of property a consumer owns.
For example, if a homeowner has a property that is valued at $300,000, and there is an outstanding balance of $200,000, the homeowner has $100,000 equity in the property.
Home equity loans, sometimes called second mortgages, are secured loans that use the equity in your home as collateral.
That means if you default on your loan, a lender can take legal action and foreclose on your home. Home equity loans are typically offered and secured by banks, mortgage companies, and online lenders.
Interest rates on home equity loans are lower than both credit cards and personal loans. Borrowers often qualify for larger lump sums with home equity loans.
Of course, the amount that will be approved on a home equity loan is based on the amount of equity in the home in relation to the home’s current market value. Lending requirements also vary based on this loan-to-value ratio, so borrowers who have more equity can have lower credit scores while borrowers with less equity can still qualify if they have very good or excellent credit ratings.
As with all types of credit, it is important to check the rates and terms to find the best deal.
Because a home equity loan is basically a second mortgage, many of the same fees associated with purchasing a home, such as origination, appraisal, legal, title search, and title insurance fees, are incurred with a home equity loan.
Since many loan companies offer “no cost at closing,” lenders roll these fees into the principal, which increases the amount of interest you pay on the loan.
Like a traditional mortgage, home equity loans are paid in fixed monthly installments over a predetermined payoff period.
Key Takeaways
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Home equity loans are contingent upon a borrower’s loan-to-value ratio.
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Loan requirements may vary, but many applicants can qualify.
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Home equity loans are secured, using the home as collateral.
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Payments are made in fixed monthly installments.
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Closing fees apply.
Advantages of Debt Consolidation
Simplified Payments
You can save money on late fees and prevent your balance from growing unnecessarily because you are less likely to miss a payment when several high-interest debts are consolidated into a single manageable payment.
Potential Savings
You can save money over time with a lower interest rate.
Credit Score Impact
You can improve your credit score by making more payments on time, improving your debt-to-income ratio faster, and paying off your consolidated debt sooner.
Cons of Debt Consolidation
Fees and Costs
Origination fees, balance transfer fees, or closing costs can add up.
Secured Debt Risks
If using a home equity loan, you risk losing your home if you fail to make payments.
Increased Total Interest
While monthly payments may be lower, extending the term can increase the total amount paid in interest.
Debt consolidation is a useful tool for those struggling to manage multiple debts, but it requires careful consideration of the terms and potential risks involved.
If you are considering debt consolidation, discuss your options with a loan specialist at AMG Finance. Our lending team has the expertise and experience to help you determine which type of debt consolidation will work best for you.
